by the author of dead companies walking

Category Archives: wall street shenanigans

Stocks have soared ever since Donald Trump stunned everyone by winning the presidency, but Trump’s victory was far from a landslide mandate. Hillary Clinton won the popular vote by over 2.6M votes. This marks the fifth time a president has won the electoral college but lost the popular vote—and Trump’s popular vote deficit was much larger than the previous four times this election outcome occurred.

But before Democrats claim a moral victory, they would be wise to examine the congressional tally. According to the Wall Street Journal, Republicans won 3M more House votes than Democrats. That means a staggering 5.5M voters picked Clinton and then voted for a Republican congressional candidate—which not only speaks volumes to Trump’s personal unpopularity, but to the rightward drift of white voters.

After one of the longest, weirdest, and most exhausting election seasons in our history, we are only six days away from (finally) choosing a new president. As importantly, 34 Senate seats and all 435 House seats are up for grabs.

Investors are justifiably nervous about the outcome. Yesterday’s selloff was probably a symptom of that unease. Betting markets currently predict Hillary Clinton has a 70-75 percent chance of winning. I suspect her odds are much better. Four years ago Obama’s five million vote victory was fueled by a 56 to 44 percent majority of female voters and an even greater 74 to 26 percent majority of Hispanic voters. I am 99 percent certain Trump will do worse with both groups. Ever since he announced his candidacy Republican leaders (and media talking heads) have known that women and Hispanics would be his Achilles heel and yet, shockingly, he has made no effort to improve his appeal to these voters. Either he is delusional about his chances or simply refuses to learn the daunting math required for a Republican to win the general election.

The Donald’s only hope is the fact middle-of-the-road voters seem to dislike Hillary almost as much as they dislike him.

Stock picking is hard. Most institutional and retail stock pickers underperform the indexes. But every investor could improve the likelihood they beat the market by following one rule:

Avoid high profile, controversial companies where an adverse news event could produce an overnight price collapse.

Three stocks have proven the utility of this investing rule in spades: Valeant Pharma, Wells Fargo, and Mylan Labs. All three have been scrutinized for behavior labeled unethical by some and illegal by others, and all three have cost their investors in a big way because of it.

Wednesday marked the fortieth birthday of the most investor-friendly idea in stock market history: the index fund. Forty years ago Vanguard introduced the first fund that merely tracked the S&P 500. It has appreciated 6,334 percent since inception, trailing the S&P by a mere .14 percent annually, all of which was the ‘expense ratio’ charged investors. Few, if any other funds have matched or exceeded this annual return.

Today roughly $5 trillion is invested in index funds. Vanguard is the largest index manager, with over $3 trillion in assets under management (AUM). Other money managers now offer index products alongside their traditional, actively managed funds.

Study after academic study shows that index funds outperform most actively managed funds. The reason is simple. Fees. The average expense ratio for actively managed stock funds is around 1.5 percent. It is somewhat less for fixed income funds. As Vanguard founder John Bogle has convincingly shown, a fund with a 1.5 percent annual fee (and the same pre-fee annual return) will produce a much smaller total return over a multi-year period than a fund with a .14 percent annual fee.

Investors have taken notice. According to the Wall Street Journal, they have invested $409 billion in passive index funds in the last year and pulled $310 billion out of actively managed funds over the same period. Roughly 20 percent of all money in stock funds is now indexed, up from zero 40 years ago.

Wall Street has always been captivated by controversial companies, controversial leaders, and controversial mergers. Tesla’s shocking offer to buy SolarCity on Tuesday featured all three, so it was no surprise that the deal instantly seemed like a bigger story than the presidential race, gun control, ISIS, and Brexit. It even managed to make the last controversial company that dominated headlines, Valeant Pharma, seem like an afterthought.

A few people have written in asking my opinion of the deal. The short answer is, I believe investors are well advised to avoid both stocks like the plague. As separate entities, these companies are wildly overvalued story stocks with a good chance of going broke. Together, they will form one wildly overvalued story stock with a good chance of going broke.

Earnings, as the old Wall Street adage goes, are “the mother’s milk of stock prices.” But not all earnings are the same. More and more companies believe they can hoodwink investors into accepting the myth that non-GAAP earnings are a better measure of corporate progress than numbers produced by generally accepted accounting principles. In 2016’s first quarter, 19 of the 30 Dow companies reported both GAAP and non-GAAP earnings.

In theory, filing non-GAAP numbers can give a clearer picture of a company’s health by excluding expenses managements consider (or hope) to be nonrecurring, such as charges for divestitures, acquisitions, and foreign currency adjustments. In practice, non-GAAP figures increasingly allow managements to present wildly distorted pictures of their firms’ financial health by omitting the most troublesome aspects of their balance sheets. Valeant is all over the news now for doing just that. But the biggest and, mystifyingly, least talked about expense omitted in non-GAAP numbers is stock based compensation.

Two high profile commodity companies filed for bankruptcy last week. The first was St. Louis-based coal producer Peabody Energy (BTU). Peabody was the latest coal producer to file, following Arch Coal, Alpha Natural Resources, Patriot Coal, and Walter Energy. BTU quickly fell below $1 on the news. Just a few years ago, Peabody’s market capitalization exceeded $20 billion. On Wednesday, Houston offshore oil producer Energy XXI (EXXI) joined Peabody in bankruptcy court. Four years ago, EXXI was a $32 stock. On Thursday, the day after it announced its bankruptcy filing, it closed at 12 cents.

With yesterday’s 300-point collapse, the Dow is now down 7.3 percent since January 1st. Other indexes have cratered as well. The smaller company Russell 2000 has shed over 11 percent. In the midst of this carnage, investors are understandably searching for “safe haven” stocks that generate dividends, are inexpensive, and offer less volatility than the overall market. Unfortunately, these ports in the storm are few and far between at the moment. People are looking for any excuse to sell stocks right now, which means anyone looking to buy has to be particularly sensitive to headline risk.

Today no sector faces greater headline risk than the biotechnology and pharmaceutical space, especially companies that have engaged in price gouging. In this toxic environment, names like Valeant, Shire, Vertex, BioMarin, and others are the financial equivalent of the Zika virus.

On the plane ride back from the Booth Investment Management Conference in Chicago on Sunday, I read the great new book by veteran financial journalist Bethany McLean, Shaky Ground: The Strange Saga of the US Mortgage Giants. The book tells the story of Fannie Mae and Freddie Mac, the two massive GSEs (government sponsored enterprises) that buy, package, and sell pools of mortgage loans. It’s a fascinating, if distressing history. Unfortunately, because our government failed to do away with Fannie and Freddie during the 2008 financial crisis, that history is still unfolding.

The Valeant saga is probably a long way from a resolution. Anyone that says they know how it will end is either delusional or looking to influence the stock. That being said, there are a few lessons to be gleaned:

"[Scott Fearon's] insights on the common ways that mature companies often doom themselves apply equally well to start-ups. Every business, young or old, needs to avoid the ... mistakes that he outlines."

About the Author

Scott Fearon has spent thirty years in the financial services industry.
Since 1991, Scott has managed a hedge fund in Northern California that invests in fast-growing companies with little or no Wall Street coverage while shorting the stocks of distressed businesses on their way bankruptcy.